Back To: BUSINESS ENTITIES, CORPORATE GOVERNANCE, & OWNERSHIP

What is Entity Theory?

The entity theory is a fundamental concept assuming that the activities carried out by an organization are separate or distinct from its owners. This theory revolves around the belief that the activities of a business organization are dependent from those of its owners. This covers the concept of limited liability, and the sense of distinction between owning and controlling the company. According to entity theory, owners of a company cannot be held personally liable for its debts and liabilities. Hence, creditors cannot acquire the personal assets or property of the owner for recovering the remaining debt amounts. However, critics find the entity theory irrelevant because of not showing a realistic relationship in the actual business world. Also, it seems to be of no worth for limited liability company (LLC) accounting standards.

How Does Entity Theory Work?

Considering the significance of ownership and control, it is important for business owners to have limited liability in the company. For establishing and following a policy that creates distinction between owners and company, as well as their respective liabilities, the organization sets standards to keep organizational funds separate from those of its owners. The whole business industry in the global markets considers separating the personal and official business operations. Entity theory has a huge role to play in the accounting industry. It is formed on the basis of this following accounting equation: 

Assets = Liabilities + Shareholders Equity 

Here, liabilities is the total of all current liabilities and long-term obligations or debts of the company, while stockholders equity consists of assets that shareholders receive after paying off all liabilities. As per the entity theory, liabilities refer to equities that have distinct legal rights in the organization. Considering the accounting perspective, the entity theory considers company's monetary aspects such as liabilities, assets, incomes, revenues, etc. distinct from the owners personal expenses and money-related operations. Hence, this leads to the separation of identity for owners and managers, and the company itself. For courts, companies are considered to be legal persons, meaning that the company can have ownership of assets, real estate, borrow funds from financial institutions, make agreements, etc. Companies can sue and be sued, and their owners and managerial levels are not personally held liable to the creditors.

Criticism of Entity Theory

The entity theory was founded back then in the 19th century. In spite of being in existence for so many years, the theory has not succeeded much in gaining more recognition worldwide. This is somehow because of the criticism that this theory has received from several researchers. An organization is not independent from its owners, rather it is a source that owners use for reaping profits. Such profits are, in one way or the other, attached to the interests of owners and managerial committee. Their motives are just like the company's stakeholders. This means that owners tend to make investments in the firm with a view to earn returns on them. Besides contributing to a firms capital structure, these investments include efforts, knowledge, hard-work, time, and so on.

Related Topics

• Business Entities (Intro)
• Why is studying business entities important?
• Considerations When Forming a Business Entity
• Holistic (Detailed) Overview of Setting Up a Business Entity
• What are Business Entities?
• What is a Closely-held vs Publicly-held Business?
• What are the main types of business entity?
  
• What are the primary characteristics of business entities?
• What is Creation of a business entity?
• Where to Form a Business
• Incorporating in Delaware
• Forming an LLC in Nevada or Wyoming
• Creating a Company Offshore
• Promoter
• Promoter Liability
• De Jure Corporation
• Ultra Vires
• Brassplate Company
• What is Maintenance of a business entity?
• What is Continuity of a business entity?
• Business Continuity Planning
• Buy Sell Agreements
• Shotgun Clause
• Winding Up
• Dissolving a Foreign Qualification
• What is the Ownership structure of a business entity?
• Joint Stock Company
• Parent Company
• Subsidiary Company
• Wholly-Owned Subsidiary
• Operating Subsidiary
  
• Holding Company
  
• State-Owned Enterprise
• Mutual Company
• Conglomerate
• What is Control of a business entity?
• What is Personal liability of owners of a business entity?
• Entity Theory
• Piercing the Corporate Veil
• What is Compensation of business owners?
• What is Taxation of a business entity?
• What is Sales & Use tax?
• What are payroll and self-employment taxes?
• What are the major characteristics of a Sole proprietorship?
• Uniform Partnership Act
• Uniform Limited Partnership Act
• Partnership Agreement
• At-Will Partnerships
• Responsibilities of Partners to the Partnership
• Silent Partner
• Funding the Partnership
• How are Partners Compensated
• Splitting Equity in an Industrial Partnership
• Terminating the Partnership
• Types of Partnerships
• What are the main characteristics of a General partnership?
• Tort Liability of General Partner
• What are the main characteristics of a Joint venture?
• What are the main characteristics of a Limited partnership?
• Family Limited Partnership
• Master Limited Partnership
• What are the main characteristics of a Limited liability partnership?
• What are the main characteristics of a Limited liability company?
• Forming an LLC
• Articles of Organization
• Operating Agreement or LLC Agreement
• Why You Need an LLC Agreement
• LLC Compensation of Members
• LLC Taxation
• Converting to an LLC
• What are the main characteristics of a Corporation
• Articles of Incorporation 
• What to include in the Articles of Incorporation
• Corporate Bylaws
• Exiting the Corporation
• Dissenter's Rights
• What are the requirements to be an S Corporation?
• Non-Profit Organization
• NonProfit Business Entities
• Private Foundation
• A Detailed Explanation of the Sole Proprietorship
• Taxation of Sole Proprietorship
• A Detailed Explanation of the General Partnership
• 50/50 Partnerships: Never a Good Idea
• Publicly-Traded Partnerships
• A Detailed Explanation of the Limited Liability Company
• A Detailed Explanation of the Corporation
• Keepwell Agreement (Letter of Comfort)
• Personal Service Corporation Definition
• A Detailed Explanation of the Non-Profit Entity
• Public Limited Company (UK)